Many of the cash flows in the project are based on assumptions that have an element of uncertainty. The present day cash flows, such as capital cost, energy cost savings, maintenance costs, etc can usually be estimated fairly accurately. Even though these costs can be predicted with some certainty, it should always be remembered that they are only estimates. Cash flows in future years normally contain inflation components which are often “guess-timates” at best. The project life itself is an estimate that can vary significantly.
Sensitivity analysis is an assessment of risk. Because of the uncertainty in assigning values to the analysis, it is recommended that a sensitivity analysis be carried out – particularly on projects where the feasibility is marginal. How sensitive is the project’s feasibility to changes in the input parameters? What if one or more of the factors in the analysis is not as favourable as predicted? How much would it have to vary before the project becomes unviable? What is the probability of this happening?
Suppose, for example, that a feasible project is based on an energy cost saving that escalates at 10% per year, but a sensitivity analysis shows the break-even is at 9% (i.e. the project becomes unviable if the inflation of energy cost falls below 9%). There is a high degree of risk associated with this project – much greater than if the break-even value was at 2%.
Many of the computer spreadsheet programs have built-in “what if” functions that make sensitivity analysis easy. If carried out manually, the sensitivity analysis can become laborious – reworking the analysis many times with various changes in the parameters.
Sensitivity analysis is undertaken to identify those parameters that are both uncertain and for which the project decision, taken through the NPV or IRR, is sensitive. Switching values showing the change in a variable required for the project decision to change from acceptance to rejection are presented for key variables and can be compared with post evaluation results for similar projects. For large projects and those close to the cut-off rate, a quantitative risk analysis incorporating different ranges for key variables and the likelihood of their occurring simultaneously is recommended. Sensitivity and risk analysis should lead to improved project design, with actions mitigating against major sources of uncertainty being outlined
The various micro and macro factors that are considered for the sensitivity analysis are listed below.
Micro factors
• Operating expenses (various expenses items)
• Capital structure
• Costs of debt, equity
• Changing of the forms of finance e.g. leasing
• Changing the project duration
Macro factors
Macro economic variables are the variable that affects the operation of the industry of which the firm operates. They cannot be changed by the firm’s management.
Macro economic variables, which affect projects, include among others:
• Changes in interest rates
• Changes in the tax rates
• Changes in the accounting standards e.g. methods of calculating depreciation
• Changes in depreciation rates
• Extension of various government subsidized projects e.g. rural electrification
• General employment trends e.g. if the government changes the salary scales
• Imposition of regulations on environmental and safety issues in the industry
• Energy Price change
• Technology changes
The sensitivity analysis will bring changes in various items in the analysis of financial statements or the projects, which in turn might lead to different conclusions regarding the implementation of projects